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The Baltic Dry Index (BDI) has fallen 28% from its recent high on May 26th, indicating to some weakness in the global economy. The BDI tracks the prices of bulk carriers which are the life-blood of global trade carrying everything from iron ore to grain. While the 28% decline may seem ominous, the BDI is being influenced by two outside factors that have very little to do with global economic health. The first factor is that during shipping’s boom period, prior to the recession, a record amount of new ships were ordered that are only now being delivered creating a supply glut in the sector, while demand remains tepid at best. Secondly, China’s unprecedented stimulus package, stoking the country’s demand for raw materials through new lending and infrastructure projects, gave the country enormous sway over the index as they were receiving the vast majority of dry bulk goods. Further tightening in China without substantial offsetting demand increments from the remainder of the world—which are returning, but at a gradual pace—along with an armada of vessels coming online over the next several month will likely place continued pressure on the BDI, but not necessarily indicate a slowdown in the global economy.

Trade, the life blood of the global economy, has begun rebounding nicely since the trough of the global economic crisis. But, January’s US trade data unexpectedly displayed a decline in both exports–the first decline in nine months–and imports, leading to a smaller US trade deficit, but also implying a potential slowdown in global trade. As I said, one month does not indicate the start of a trend, but this is something that should be monitored moving forward. The chart below illustrates the relationship between the U.S. trade deficit and the Baltic Exchange’s Baltic Dry Index (BDI). As you can see the sharp decline in the US trade deficit during the economic crisis–indicative of a slowdown in global trade–coincided with a collapse in shipping rates as measured by the BDI.

Cantor Fitzgerald raised the price target for Diana Shipping (DSX) to $18 from $16 based on higher rechartering assumptions. Cantors presently holds a ‘Buy’ rating on DSX. DSX is one of the few shippers within the dry bulk space on which I hold a relatively constructive view. Compared to other shippers the company has a healthy balance sheet, and is well position to take advantage of distressed asset prices. In fact the company recently initiated a two year expansion program with its purchase of a new vessel.

Source: Bloomberg & Capital Link

Shipping rates over the near-term will likely remain volatile. Why? China. China still holds a disproportional influence over shipping rates, and when a single player holds that much sway, volatility is inevitable, especially when that player is China. Therefore, anyone closely following the shipping sector needs to be very aware of what is happening in China. The secondary driver is of course a tug-of-war between a growing supply of ships and gradual increments in global demand for the service. Over the long-term, shipping rates should remain volatile through-out the year, but on average remain relatively subdued.

Carrying over from a theme I mentioned earlier this week in my column on thestreet.com, I began contemplating what frequent transportation index, if any, would be a good complement the BDI as a forward looking indicator toward the global economy. My goal was to find something that could perhaps help factor out the impact of some of supply glut in dry bulk shipping sector. What I mean is I wanted to find something that if moving up in conjunction with the BDI would almost certainly be good news for the global economy. Concurrently, if the BDI was to remain static while the complementary index rallied, we might get some insight into the over supply of ship’s impact on the BDI. After a few moments of thought I believe I found that index.

The major rail companies in North America release a weekly metric on railroad performance, which among other things measures the total number of rail cars on line. I briefly mentioned this index in a piece I published several weeks ago, showing the strong correlation between CSX’s cars online and the BDI (see chart).

Source: Bloomberg, Capital Link, CSX

However, to get a true gauge of potential economic performance we would need to include more than just CSX, hence I created an aggregate index with car on line data from the following companies: BNSF Railway Company, Canadian Pacific, CSX Transportation, Kansas City Southern, Norfolk Southern, and Union Pacific Railroad. Once you factor in these additional companies the relationship becomes far less apparent (see chart).

Source: Bloomberg, Capital Link, Railroad Companies

The reason behind this will be fodder for another article, but it is possible that CSX has a higher exposure to the commodities, which were in high demand from China. Nevertheless, what has been a horrible year in terms of aggregate rail volumes looks to be bottoming. I recently heard from executives running most of the companies within this aggregate index, and in general their outlooks confirmed a possible bottom, but by no means a rapid recovery. They were are also optimistic regarding the effects a potential record US harvest could have on rail volumes, a view echoed by participants in the panamax sector. Finally, this is more or less in-line with my view that the US and developed nations will return to growth, albeit at a measured pace, with developing nations outpacing the developed world. Now, lets see if the BDI and rail car volumes will agree…

I have received several inquiries regarding the recent divergence between the BDI and my dry bulk shipping index (DBSI), and thought I should touch on the subject. First and foremost I believe that a large portion of the divergence can be explained as a US dollar story. Also, recent weakness has been mostly isolated to larger capesize vessels, which means shippers with low or no exposure to that sector have been somewhat buffered. Prior to the global financial crisis, a weakening dollar helped lead to an unprecedented surge in commodity prices and shipping rates, this had a direct positive impact on shippers’ asset values and rates. As the crisis hit investors around the globe became more risk averse and flocked into US government debt. This liquidation of risky assets caused a massive retrenchment in commodity prices and a significant rally in the US$. Now however, as investors again grow less risk adverse, the value of the greenback has begun to depreciate, and with it we are again seeing a rally in commodity prices and flows back into riskier assets. However, unlike the prior example we have not seen, and are unlikely to see, any significant appreciation in shipping rates over the near-term, more on this later. But, speculation over what some believe may be a V-shaped recovery have potentially over-valued some assets that could experience a possible sell-off, leading to a interim increase in risk aversion and an appreciation in the dollar. Don’t get me wrong, I do believe the overall global economy is improving, however, I feel it will be at a more measured pace with some volatility, and in this context I believe some debt spreads and equity markets could be overvalued. This is especially true in the shipping sector.

Source: Bloomberg & Capital Link

The chart below overlays my DBSI with the inverted US$ index, and as you can see the correlation over the last few months has been very significant. This relationship also explains why the DBSI has largely been ignoring declines in the shipping rates. At least over near-term, it appears that a bet on the sector essentially equates to a bet against the US$. As I mentioned yesterday, another reason the temporaneous breakdown in the relationship between shipping rates and the DBSI is shippers’ higher proportions of fixed long-term contracts, reducing the sensitivity to the BDI, however, this also limits upside. In conclusion, an appreciating greenback will only move shippers’ stocks up so far, without a corresponding increase in shipping rates, which is not on the horizon. Therefore, with the bleak outlook for shipping rates combined with the potential for what I believe could be another market correction before growth returns on a more measured pace, I would be hesitant to place any long positions on the sector at current values.

Source: Bloomberg & My Calculations

As an aside: FBR Capital Markets, this morning published a bearish report on the dry bulk sector due what they believe will be relatively few order book cancellations. The company said, “After our recent meeting with the largest and most advanced shipbuilder in China, China Shipbuilding Industry Corporation (CSIC), in Beijing, China, we reiterate our Underweight position on the dry bulk industry. CSIC confirmed our thesis that there will be fewer-than-expected order book cancellations.” My DBSI returned some recent gains yesterday falling -1.1%. The index is still realizing a weekly return of 9.1%

A potential record US harvest could help buoy rates for small to mid-size ship rates. What was a relatively mild and wet spring and summer has created conditions for what is setting up to be one of the nation’s biggest harvests. The U.S. Department of Agriculture is projecting a total corn crop of 12.954bn bushels, which would be the second highest on record, and a record soy bean crop of 3.245bn bushels. Some industry analysts believe these estimates could even be conservative, without a September frost. The weather conditions that have led to this potential harvest haven’t come without some risks; cool temperatures have pushed back harvest time by up to two to three weeks, which increases the chances of a September frost in the mid-west farm belt. As an aside, changes in the near-term weather forecast for the mid-west could have a large impact on grain prices. Optimal conditions would be sunny 80 degree days, whereas any frost forecasts before the completion of harvest could place some upward pressure on prices.

Source: USDA

So what does this have to do with shipping? While the US experienced optimal crop conditions, other countries, like China, have faced sub-par conditions and have reduced production of soy beans. Overall the US supplies 45% of the world’s soy bean exports. In 2008 China imported 37.44mn tons of soy beans, which according to my calculations is roughly 1.3bn bushels, with nearly 99% coming from the US, Brazil, and Argentina. In fact, in 1Q09 80% of China’s record soy bean imports were from the US. Early indications on the US Gulf Coast, where most domestic grain is shipped to China have been positive. Lloyds List, a leading maritime and transport news terminal, quoted one regional broker saying, “The US Gulf has come alive with a bit more inquiry for October, and going forward, a number of sales have been done.” He went on to say, “The Chinese have bought quite a lot of grain out of the US Gulf, and those inquiries have either been with the Chinese or the grain houses.” This should be especially positive news for panamax rates, which are facing pressure from both decreased iron ore and coal demand. Capesize rates are unlikely to benefit much, if at all, from this demand as they are not typically involved in grain trade.

In retrospect, the widespread panic that engulfed the world’s financial markets after the fall of Lehman Brothers may have been somewhat overblown considering the actual long-term impact of the event, which was significantly mitigated through innovative monetary policy. But at the time, this did not prevent an almost immediate shut-down of credit markets around the world affecting most, if not all, facets of the global economy. The shipping sector was no exception. Within shipping there is an essential financial instrument called a ‘Letter of Credit’ (LOC). LOCs facilitate the bulk of global trade by guaranteeing the buyer’s funds will be delivered to the seller upon delivery of the goods. These instruments are issued mostly by financial institutions.

As I mentioned, Lehman’s demise led to an immediate lockup in global credit markets, including LOCs. To help quantify this I created the chart below, which plots the TED spread against the BDI from 2006. For this application I slightly modified the traditional TED spread and used 3M LIBOR Basis Swap against the Fed Funds rate; this measure acts as a yard stick on implied counterparty risk as LIBOR is the rate at which banks are willing to lend to each other. You will notice that the unprecedented jump in the TED spread coincides with an extraordinary drop in the BDI from a peak of nearly 12,000 to a low of 663 in only a matter of months. To help put this into perspective, an article by “The Independent” noted that in June 2008 a shipment of coal from Brazil to China would have totaled US$15mn per voyage compared to US$1.5mn by October, and rates moved even lower from there.

Source: Bloomberg & Capital Link

Without LOCs, the shipping sector came to what was essentially a standstill. Even where demand still existed, buyers were unable to get the credit to guarantee payments. A quote from an article in the Financial Post published in October of last year put it best, “There’s all kinds of stuff stacked up on docks right now that can’t be shipped because people can’t get letters of credit,” said Bill Gary, president of Commodity Information Systems in Oklahoma City. “The problem is not demand, and it’s not supply because we have plenty of supply. It’s finding anyone who can come up with the credit to buy.”

How times have changed. In the year since Lehman’s collapse, credit conditions have improved considerably, as demonstrated by the TED spread, which has begun reverting back toward its historical average. Better credit conditions have provided increased liquidity allowing buyers around the globe easier access to LOCs. This alone however does not mean smooth sailing for the shipping sector, but what it does mean is that the sector is highly unlikely to re-test the lows experienced during the end of 2008 and early 2009.

The Baltic Exchange’s Baltic Dry Index (BDI) rose by 0.6% today, reaching its highest level since 8/24. But, these gains have come on continued weakness in the Capesize sector where rates have fallen for eight consecutive days, losing an additional 2.1% this morning. Rates on smaller vessels, especially panamax, have fared much better over recent weeks helping to support the overall BDI. The Baltic Panamax Index, which gained 2.5% this morning is now up 18.2% on a weekly basis, offsetting the BCI’s decline of 10.2% during the same time period. As I outlined last week in my column for TheStreet.com Panamax rates have likely reached an interim bottom, and should continue to show some moderate strength and stability, Capesize rates will likely face some additional downside.

Downside risk remains in place for the sector through a potential supply glut of ships and reduced new lending in China, leading to a reduction in the country’s demand for dry bulk imports. Possible upside risks are a possible uptick in demand due to the restocking effect of depleted US business inventories, and fewer than anticipated deliveries of newbuild vessels. But, without an increment in consumer demand these positive effects could be temporary. For full details on my views on the sector please see my daily shipping column on TheStreet.com’s RealMoney section.

As seaborne shipping acts as the bridge for global trade, the US’s railroad and trucking systems are the backbone of domestic bulk transport. It goes without saying that at some point the majority of goods imported to or exported from the US likely find themselves traveling on a rail car or truck before reaching their final destination. Therefore, I wanted to analyze those sectors for any potential relationship to the BDI. Step one in this process, was finding an appropriate indicator to compare railroad activity against the BDI. This step was straight forward as the Association of American Railroads (AAR) publishes a weekly report measuring railroad freight volumes by company. In the chart below I graphed the BDI against the number of cars on line for CSX on a weekly basis.

Source: AAR & Bloomberg

As you can see from the chart above the correlation between rail car volume and the BDI over the past year has been very significant., and in some cases railroad activity actually led the BDI. One possible cause for this relationship is coal. Nearly one third of US railroad volumes are coal shipments, and in 2007 36mn tons of this coal was exported. Given the relationship between the BDI and railroad volumes, diminishing railroad activity in the US is yet another factor painting a macabre picture for the shipping industry. On a year to date basis coal and grain railroad shipments are down 9.3% and 22.4%, respectively. Metal and ores, which make-up only about 3% of US railroad volumes are down over 50% year to date.

But, in order to fully grasp the implications trucking and railroads may have on shipping it is critical to understand the supply and demand factors driving the sectors along with the outlook and physical linkages between the sectors. I could open a dialogue on this immediately, but will wait until after an upcoming industry conference I am attending where I should have the opportunity to speak with the management of some major US railroad and trucking companies. Expect an update on this come mid-month.

P.S. I apologize for not having any real-time updates today, as I am in the process of relocating offices.

Capesize rates have come under considerable pressure over the past week with forward contracts losing roughly 14% of their value over concerns on industry fundamentals. Despite what has already been 5 consecutive days of declines for capesize rates, industry experts believe this week could bring even more downward pressure. According to Lloyd’s List, a leading maritime and transport news terminal, plummeting demand in the capesize sector is coinciding with what is a significant amount of vessels coming of long-term charter contracts, essentially creating the perfect storm. One Hong Kong shipbroker quoted in the report believed rates “would fall to around $35,000 per day by the middle of this week and could even fall below $30,000 per day by next Friday.” Furthermore, there doesn’t appear to be any relief insight over the near-term as noted by a Shanghai based shipbroker, “With iron ore prices falling and inventory levels at Chinese ports at less than 72m tonnes, there does not seem much prospect of an increase in ore imports after the record levels seen in June and July.” Iron ore inventories in China last week were reported up 240K tones to 71.2m tones, or 20% higher than the levels experienced in early June. Those shippers who increased contract coverage to near 100%, while rates were elevated should still continue to benefit. In addition to Chinese iron ore prices falling, steel prices have also declined, dropping almost 7% over the past week.

Contact Me:

Michael.McDonough@fiateconomics.com
Michael is an economist/strategist who has worked from Wall Street to Hong Kong primarily focusing on the U.S. and emerging markets. He has also written several columns. More

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